China’s Monetary and Exchange Rate Policy

Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People’s Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet…

In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

As this paper from the Bank of Japan explains in detail, China’s money market operations are largely subordinate to the requirements of its managed exchange rate regime.

Comments

This (correct) argument is essentially a restatement of the fixed exchange rate “problem” which argues that, under a fixed exchange rate, monetary policy is emasculated. As a result, a central bank has no control over money supply growth under these conditions and inflation will rise/fall to push the real exchange rate to its appropriate level. I think this idea has been stated in the past for China by Warwick McKibbin. What we see in China is CPI infaltion offically recorded at 3.0%, which is not very different from US inflation at 2.7%. On this (admittedly limited) metric alone, it suggests that the RMB may not be too far away from equilibrium. However, there may be two problems with this. Perhaps China’s inflation is higher than the offical CPI figures suggest. Second (and related) inflation may not be occurring in consumer prices but in asset prices (i.e. rising equity and property markets). Rising asset prices increase the cost of capital and therefore reduce international competitiveness just as an appreciating currency would.

Posted by .(JavaScript must be enabled to view this email address) on 05/23 at 10:25 AM